What Is the Optimal Top Marginal Income Tax Rate?

It’s not just American bureaucracies that are headquartered in Washington, D.C. The International Monetary Fund (IMF), with its staff of approximately 2,700, has been headquartered in Washington, D.C., since its inception in 1945.

The IMF “is an organization of 189 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.” The IMF “monitors member country policies as well as national, regional, and global economic and financial developments through a formal system known as surveillance” in order to “maintain stability and prevent crises in the international monetary system.” The IMF provides “loans to member countries that are experiencing actual or potential balance-of-payments problems.” Its primary aims are to:

Promote international monetary cooperation;

Facilitate the expansion and balanced growth of international trade;

Promote exchange stability;

Assist in the establishment of a multilateral system of payments; and

Make resources available (with adequate safeguards) to members experiencing balance-of-payments difficulties.

The IMF is funded by a quota system: “Each member of the IMF is assigned a quota, based broadly on its relative size in the world economy. This determines its maximum contribution to the IMF’s quota resources.” The current quota formula “is a weighted average of GDP (weight of 50 percent), openness (30 percent), economic variability (15 percent), and international reserves (5 percent).” Quotas “are denominated in Special Drawing Rights (SDRs), the IMF’s unit of account.” The United States is the largest member of the IMF with a quota of SDR82.99 billion (about $118 billion), or about 17.46 percent of the IMF’s total funding.

Twice a year the IMF publishes its Fiscal Monitor, a report that “analyzes the latest public finance developments, updates medium-term fiscal projections, and assesses policies to put public finances on a sustainable footing.” Its most recent report, issued last month, is titled “Tackling Inequality.”

According to the executive summary of “Tackling Inequality,”

Rising inequality and slow economic growth in many countries have focused attention on policies to support inclusive growth. While some inequality is inevitable in a market-based economic system, excessive inequality can erode social cohesion, lead to political polarization, and ultimately lower economic growth. This Fiscal Monitor discusses how fiscal policies can help achieve redistributive objectives. It focuses on three salient policy debates: tax rates at the top of the income distribution, the introduction of a universal basic income, and the role of public spending on education and health.

The report laments that “tax progressivity — the degree to which the average tax rate rises with income — has been on a declining trend in recent decades.” Tax policy “has an important role to play in addressing income inequality, beyond providing revenue to finance spending policies aimed at reducing inequality.” Tax policy and “the income-related transfer system in place” determine “the net distributive impact and efficiency costs associated with fiscal redistribution.” Progressive taxation and transfers “are key components of efficient fiscal redistribution.”

According to what the IMF considers to be optimal tax theory, “a less progressive tax system (such as one with a lower top income tax rate) could be the result of greater tax elasticity of taxable income, a change in the income distribution so that a smaller share of income is earned by the highest-paid individuals, or society’s placing greater weight on the welfare of high-income individuals.” “Optimal tax theory,” as explained in a footnote in the body of the report,

links the optimal income tax schedule to income tax elasticity, the distribution of income, and preferences about income inequality. The optimal top income tax rate (t*) can be calculated based on the following formula (Saez 2001): t* = (1−g) / (1−g+ae), in which g is the social welfare weight on high-income earners, a is the Pareto index, and e is the elasticity of income with respect to the tax rate. The formula simplifies to t* = 1 / (1+ae) if the marginal welfare weight is set to zero, which is simply the revenue-maximizing rate.

Since the report concludes that a decline in tax progressivity “cannot be fully explained by optimal tax theory or likely by a strong negative impact of progressivity on growth,” there “would appear to be scope for increasing the progressivity of income taxation without significantly hurting growth for countries wishing to enhance income redistribution.” This, of course, “could be difficult to implement politically, because better-off individuals tend to have more political influence, for example, through lobbying, access to media, and greater political engagement.”

So the question is asked in the report, “How steeply should marginal (and average) tax rates increase with income?” Optimal tax theory provides the answer. It “suggests significantly higher marginal tax rates on top income earners than current rates, which have been on a declining trend.”

Just how high is significantly higher?

On the basis of the optimal tax rate formula, “using an average income tax elasticity of 0.4 and a Pareto index of 2.2,” and “assuming a welfare weight of zero for the very rich” (the revenue-maximizing rate), the top “optimal marginal income tax rate can be calculated as 44 percent.”

Although the IMF never identifies the specifics of what it takes to be considered “very rich,” “better off,” one of the “highest paid individuals,” or “high-income individuals,” it is certain that those persons should hand over 44 percent of their income above some threshold to the government.

Although conservatives may criticize the IMF for a variety of reasons, figuring an optimal top marginal income tax rate should not be one of them. Conservatives have their own optimal rate, and they figure it by using the Laffer Curve, popularized by economist Arthur Laffer in the 1970s. The Laffer Curve shows “the relationship between tax rates and the amount of tax revenue collected by governments.” It is used to illustrate the truth that “the more an activity such as production is taxed, the less of it is generated.” It shows not only that “as taxes increase from low levels, tax revenue collected by the government also increases,” but also that “tax rates increasing after a certain point (T*) would cause people not to work as hard or not at all, thereby reducing tax revenue.” The argument is that governments consider point T* to be the optimal level of taxation “because it is the point at which the government collects maximum amount of tax revenue.”

The tax brackets in the United States are currently 10, 15, 25, 28, 33, 35, and 39.6 percent. It was Republicans early in 2013 who helped pass the American Tax Relief Act of 2012 (PL 112-240, H.R.8) that added the new top rate of 39.6 percent for those earning more than $400,000 a year ($450,000 for married couples).

During their presidential campaigns, Democrat Hillary Clinton and socialist Bernie Sanders both put forward new tax plans to raise the revenue needed to pay for their anticipated new government programs. Clinton proposed an additional tax bracket of 43.6 percent for taxable income greater than $5 million. Sanders proposed changes and additions to the tax brackets and a new 2.2 percent “income-based [health-care] premium paid by those in all brackets,” effectively making the tax brackets 12.2, 17.2, 27.2, 30.2, 35.2, 39.2, 45.2, 50.2, and 54.2 percent.

Liberals and progressives are always calling for higher taxes on “the rich.”

So what is the optimal top marginal income tax rate?

Optimal for whom?

Globalist bureaucrats at the IMF, conservatives, Republicans, Democrats, socialists, liberals, and progressives all agree that there is some optimal level of taxation that benefits the government. They may not agree with each other or even among themselves about what that level is, but they all agree that there is such a level that results in everyone’s paying his “fair share.”

Libertarians see things quite differently. From a libertarian perspective, the optimal top marginal income tax rate is zero. Libertarians would argue that not only should there not be progressive tax brackets that punish “the rich” and favor “the poor,” but also that there should be no tax on any American’s income in the first place. Libertarians maintain that taxation is government theft because acquiring someone’s property by force is wrong, whether it is done by individuals or by governments.

As Frank Chodorov explains in his book The Income Tax: The Root of All Evil (1954), the income tax means that the state says to its citizens, “Your earnings are not exclusively your own; we have a claim on them, and our claim precedes yours; we will allow you to keep some of it, because we recognize your need, not your right; but whatever we grant you for yourself is for us to decide…. The amount of your earnings that you may retain for yourself is determined by the needs of government, and you have nothing to say about it.”

The difference between libertarians and everyone else is that libertarians view the optimal top marginal income tax rate from the perspective of what is optimal for the taxpayer instead of what is optimal for the government.